Analyst says 94% of bitcoin's price movement over the past four years can be explained by one equation

FundStrat cofounder Tom Lee says, “if you build a very simple model valuing bitcoin as the square function number of users times the average transaction value. 94% of the bitcoin moves over the past four years is explained by that equation.”

This model is based on Metcalfe’s law, which says the value of a network is proportional to the square of the number of users on the network.

Based on this model, bitcoin has been trading at a level above the price projected by the model. FundStrat remains positive on bitcoin long-term but sees risk of a short-term correction growing.

Tom Lee, cofounder of FundStrat Global Advisors, is bullish on bitcoin and has a unique way of valuing the cryptocurrency. His short-term valuation model is built on Metcalfe’s law, and he says it can explain the vast majority of bitcoin’s volatility. He explained his reasoning to Business Insider on our cryptocurrency show, “the bit.”

Metcalfe’s law basically says that the value of a network is proportional to the square of the number of users on the network.

For example, consider the fax machine — which is utterly useless if you are the only one who has one. The value increases exponentially as other people get fax machines. This is also true for social networks. Facebook is valuable because so many of your “friends” are on it. It’d be a boring place to surf alone. Or as Lee puts it, “if you double the number of users, you’re more than doubling the utility value.”

Lee contends that the same is true for bitcoin. FundStrat looked at unique addresses as a proxy for users on the bitcoin network and found the square of this value explained 63% of the variation in bitcoin prices since 2013.

Lee: Yeah, in the short-term we think bitcoin has really followed very closely the idea of acting like a social network. Meaning the more engagement there is, the greater the value rises. And in the short-term, we think bitcoin will reach at least $US6,000 by mid-2018.

Silverstein: And you’re using Metcalfe’s Law, can you explain that?

Lee: Yeah, so Metcalfe’s a professor. He actually came up with a theorem based on George Gilder, which is the value of a network is the square of the number of users. And so if you build a very simple model valuing bitcoin as the square function number of users times the average transaction value. 94% of the bitcoin moved over the past four years is explained by that equation.

FundStrat expanded their short-term model by adding bitcoin transaction volume per user. This linear factor explained 83% of the variation in bitcoin’s price by itself.

FundStrat was able to find a formula by regressing the price of bitcoin against both unique addresses squared and transaction volume per user. This model explained 94% of the variation in the cryptocurrency price since 2013.

The following chart plots the projected price of bitcoin based on this model (light blue) against the actual price of bitcoin (dark blue dotted line). As you can see, the model is relatively good fit through mid-2017.

FundStratThe price of bitcoin compared to the projected value of bitcoin based on the FundStrat model using unique addresses and transactions.

FundStrat can then use this model to project the future value of bitcoin. The model requires an estimate for the number of unique addresses on the bitcoin network (squared) and an estimate for the number of transactions per day.

According to Lee, the model provides “a method to suggest a short-term range for bitcoin.” Given this premium, Lee is a little more cautious in the short-term.

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